As some of the largest subprime mortgage lenders teeter on the edge of bankruptcy, ABS investors are turning an increasing amount of attention to the quality of servicing those loans might be receiving.
Based largely upon a grim liquidity outlook, Fitch Ratings and Moody's Investors Service last week lowered the subprime servicer ratings of both Fremont General Corp. and New Century Financial Corp. to the equivalent of "below average," while Standard & Poor's placed both on a negative watch. The ratings single out the two top-five subprime mortgage lenders as maintaining the lowest-rated servicing shops under surveillance by the rating agencies. Moody's on Feb. 22 placed the servicer ratings of Accredited Home Lenders, Ameriquest Mortgage Co., Novastar Mortgage and Specialized Loan Servicing on watch for a downgrade.
Rating agencies and investors worry that financial stress and its implications such as layoffs and staff turnover could result in lower servicing quality at a time when a number of adjustable-rate subprime loans are due to reset. "One of the most important factors is the financial position of the servicer," said Michael Drucker, an analyst and assistant vice president in the asset finance group at Moody's. "If the entity was in a situation that put stress on it, it may no longer have the capability of servicing outstanding or future deals."
Depending on each individual deal's pooling and servicing agreement - and the leverage yielded by residual investors - the rating changes could result in the transfer of servicing assets, and fee revenue, to a backup servicer. Pooling and servicing agreements include provisions that allow loans to transfer to a backup servicer under circumstances ranging from investor demand to pool-level delinquencies, although relatively few address financial difficulty or bankruptcy at the corporate level.
Last week, some compared the potential outcome to deteriorating subprime servicing quality - and declining capacity at the most skilled outlets - to the scenario which struck the manufactured housing market years ago. Back then, rising delinquencies met with insufficient servicing compensation.
As of Sept. 30, Fremont had $24.3 billion in its servicing portfolio, while New Century had $42 billion. A combination of declining liquidity across the subprime lending sector and an expected increase in servicing costs - as rates reset and performance worsens with loan seasoning - has a number of market participants concerned about the availability of resources for in-house servicing. "Basically our concern is that if the parent is in financial difficulty, that may impact the servicer," said Mary Kelsch, a senior director in Fitch's operational risk group.
The top five subprime mortgage servicers more or less hold high ratings from the agencies for their servicing abilities. Mortgage giant Countrywide Financial was the largest subprime servicer by the end of 2006, with a $119 billion servicing portfolio, according to Mortgage Servicing News. Chase Home Finance came in second, with an $83 billion portfolio, followed by Option One Mortgage Corp. with a $69 billion portfolio, CitiFinancial with a $64 billion portfolio and Ameriquest, with a $65 billion portfolio. Countrywide, Chase and Option One hold top servicer ratings from both Fitch and Moody's of RPS1' and SQ1', respectively. Citi holds an RPS1-minus' and SQ2' rating, while Ameriquest holds an RPS2-plus' and SQ2-plus', according to data maintained by ASR.
Notably, a decline in a servicer rating most likely translates into a higher cost of securitization if originators with lower rated servicing platforms plan to service the deal in-house. For example, a Fitch RPS4' rating means that the servicer's securitization would need either more subordination or credit enhancement in order to maintain the same rating as a higher rated primary servicer.
Yet, some of the most troubled subprime lenders do not maintain sizable servicing shops, subsequently outsourcing a fair portion of their loans to other lenders or stand-alone servicing operations. According to Bear Stearns analysts, the recently bankrupt Ownit Mortgage Solutions, ResMae Mortgage Corp. and Mortgage Lenders Network USA all ranked below 25 in terms of servicing volume in 2006. What's more, a number of financially strapped lenders have looked to selling servicing rights as a means to gaining extra revenue - or to comply with investor or trustee demands. "As a result, even though loans originated by these troubled lenders may be somewhat prevalent, the task of collecting for them will now fall toward more experienced, and in many cases, better capitalized, entities," Bear analysts wrote last week.
Assessing servicing ability, particularly in regard to the delicate nature of subprime collateral, can be challenging. According to Moody's, there are more than 250 processes involved in servicing, including such operational aspects as collection ability, loss mitigation, REO timeline management and servicing stability. Moody's claims to be the only rating agency that utilizes loan-level data normalized for collateral characteristics when assessing servicer quality.
The rating agency last month threatened to lower Accredited's SQ2' servicer rating to SQ2-'; Ameriquest's SQ2+' rating could be lowered to SQ2'; New Century's SQ3+' rating could be lowered to SQ3'; Novastar's SQ2' rating could be lowered to SQ2-'; and Terwin's Specialized Loan Servicing shop could be lowered from SQ3' to SQ3-'.
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